Private Equity and

Venture Capital
Atul Kedia
PE and Ethics
Session 15

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“Hypothetical” cases
XYZ Ltd is a publicly traded company. Mr. X, the CEO of XYZ Ltd, currently holds 13%
shares in the company. He engages with a PE group to buy out (LBO) the company and
then delists it by paying 20% premium to public shareholders. Without any further
investment by him, his shareholding goes up from 13% to 35%. The company is
immediately awarded 3 large State projects which were under negotiation for the past 6
months. The company executes these projects over the next 3 years. The company’s
shares are listed again through Offer for Sale at an effective premium of 375% vis-à-vis
what was paid to the shareholders 3 years ago.

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“Hypothetical” cases
ABC Fund invests $16 million in a venture. 5 months later, the Fund values this investment
at $23 million and raises another $35 million from LPs for follow-on investments.

Ms. Y joins a VC firm after graduating from ABC b-school. After 5 years, she creates an
alumni fund and uses another VC firm to invest these funds (contributed by alumni) in
PCos, investments being in the range of INR 1 Cr to INR 3 Cr. All these investments are
supported by her own VC firm’s co-investment with minimum INR 10 Lakhs ticket.

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PE and Ethics
PE business, by nature, is obscured by confidentiality and lacks transparency
Why do we need ethics in PE business?
Manager of money is different from investor of money
Investors’ interests need to be protected; are they sufficiently rewarded for the risk?
Regulations may not always be able to create sufficient deterrents
Conflict of interest – the probable reality of PE industry
Fundraising – how much?
Investment – whose interest to take care of?
Exit – when?
Follow-on funds vs. single fund
The race to “track record”

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PE – considerations for ethical management
Ethical practices and governance are precursor to better reputation, credibility and profitable exit
PE investment is drastically different from public investment, mutual funds, hedge funds
Larger size of holdings, longer holding period
Limited number of investee companies – high stakes
Not highly regulated
Many practices remain confidential
Higher stakes make it imp. to have higher involvement in PCo. business + influence governance
Always important to invest in companies with good governance or able to improve
Good governance is a natural protection to investors
Illiquid nature of investment adds to the importance of good governance

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Conflict of interest
Aligning interests of GPs and LPs
LPs may come to know of any material event only with a lag
Is MTM valuation the answer?
Is it practical for private investment?
Do LPs really understand the investment?
What about illiquidity of asset class?
Financial services firm with various divisions – buyout, hedge funds, distressed debt, real estate,
advisory services, M&A, private placements
Potential conflict of interest
Strong Chinese wall
Insider trading is a reality
Self-regulation is important
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Management fee and Ethics
“By far, the most common observation our examiners have made when
examining private equity firms has to do with the adviser’s collection of
fees and allocation of expenses. When we have examined how fees and
expenses are handled by advisers to private equity funds, we have identified
what we believe are violations of law or material weaknesses in controls
over 50% of the time.”

- Andrew J. Bowden, Director SEC, Office of Compliance Inspections and Examinations (2014)
https://www.sec.gov/news/speech/2014--spch05062014ab.html

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Management fee and Ethics
Unregulated industry standards – primarily demand and supply
Large fund means higher fee for GPs
Decision making with the GPs
Raise committed capital earlier than required
Delay investments or exits
Zombie funds
Track record and reputation, born out of ‘trade secrets’, define the fee
Backward looking and not forward looking
“Ideally”, agent’s mission is to manage funds for the LPs

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Transparency
Considerations for transparency, or the lack of it:
Management fee
Performance of the fund
Valuation methods
Decision making, selection of PCos., governance
GPs base their marketing pitch primarily on reputation, essentially born out of confidentiality!
Confidentiality is ‘the key’ for GPs
LPs unable to compare ‘track record’ (barriers to entry) and ongoing performance
Transparency would be a magic wand for LPs for obtaining detailed means of comparison
Transparency may not be good always
J-Curve phenomenon, lack of understanding
lack of liquidity of the asset class

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Philanthropy
Why do PEs do philanthropy and community acts?
Certificate of good behavior, appearance of morality to their activities
Reputation beyond a lifetime
It’s about the community, after all!
How to explain the reluctance to pay taxes? Are Govt. agencies not efficient in public services?
Donations by large foundations – efficient? Adverse selection?
Social venturing – how to measure impact vs easier to calculate profits? How to incentivize?
Investors for GPs vs investors for LPs  how to align all interests?
CSR – 2% of avg net profits for large companies as per Companies Act, 2013
A few initiatives:
https://www.kkr.com/responsibility/communities
https://www.blackstone.com/our-impact/corporate-social-responsibility/

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